Covenant Weekly Market Synopsis for June 21, 2019

June 24, 2019

Last Week Today. President Trump and China’s President Jinping confirmed they will meet at the G-20 Summit this week in Osaka, Japan. | The White House disclosed it had explored the legality of demoting Federal Reserve Chairman Jerome Powell due to administration’s frustration with his unwillingness to cede to President Trump’s desire for lower rates. Looks like that frustration will be addressed in July as discussed in “De-hawked” below. | Geopolitical tensions with Iran increased when the Islamic Revolutionary Guard Corps downed a $176 million RQ-4A Global Hawk, one of the U.S. military’s most advanced surveillance drones, over the Strait of Hormuz. See “Chokepoint” below.

Financial Markets. Central bankers signaling looser monetary policy (see “De-hawked” section below) gave investors the “all clear” sign to buy everything. The S&P 500 gained +2.2% while bond prices rallied to push yields lower across the board, including the global benchmark 10-year bond whose yield briefly fell below 2% for the first time since 2016. International stocks rallied as well as the Developed ex-US Index tacked on +2.6% and Emerging Markets pushing higher by +3.5%. The commodity complex was bid (Gold +4.3%, Silver +3.2%) and the potential for conflict in the Persian Gulf added to an already ebullient energy market, with WTI Crude gaining 9.7% to $57.60 per barrel. The US Dollar was the odd asset out, declining -1.4% on the week, providing a tailwind for commodities and international stocks and hope for the struggling U.S. manufacturing sector, which has been suffering from a strengthening USD.

It’s Back. Facebook revealed details of Libra, a cryptocurrency it plans to launch in 2020. Unlike other cryptocurrencies, Libra will be pegged to a basket of standard currencies, including the US Dollar and Euro, to avoid volatile price swings. Speaking of price swings, after falling from a high of $20,000 to a low of $3,200 in 2018, Bitcoin has rallied more than 240% to about $11,000 (as of the morning of June 24th).

Source: Crypto.com

De-hawked. First the ECB, then the Fed, then the BOJ. It was a week in which central bankers abandoned hopes of normalizing interest rates, in yet another sign that central banks are ill-equipped to combat global deflationary pressures ten years after the Great Recession. Indeed, the central bankers did their best to assure the markets “we got this” with regards to slowing global growth and recalcitrant disinflationary pressures. On Monday, European Central Bank (ECB) President Mario Draghi announced that the central bank is prepared to use monetary policy to stimulate the economy “in the absence of any improvement.” On Thursday, Governor Haruhiko Kuroda from the Bank of Japan (BOJ) offered the possibility of future stimulus.

Sandwiched between those two bankers, representing the world’s most important central bank, Fed Chairman Powell delivered a message on Wednesday that was even more dovish than market expectations: “In light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming economic information…and will act as appropriate to sustain the expansion…”. The phrases in bold are emphasized because for the first time this cycle, the Fed dropped its categorization of persistently low inflation as a temporary or, in Fed-speak, a “transitory” condition. That change in view explicitly clears the way for the Fed to cut interest rates to keep the expansion going. Recent weakness in the Empire Manufacturing Index (May showed the largest monthly decline in history), the Philadelphia Fed’s Manufacturing Business Outlook Survey, and the preliminary Markit Manufacturing PMI make incoming economic data over the next six weeks pivotal. If the data does not improve, look for the Fed to cut interest rates at their next meeting in July, perhaps by as much as 0.5% given Powell’s view that more aggressive action is warranted when rates are close to the zero lower bound (i.e., 0%).

Chokepoint. Most have heard of the Strait of Hormuz, especially recently with the attacks on oil tankers in the region two weeks ago and the downing of a U.S. military drone last week. Moreover, references to the importance of the region to global oil supply are common. But how much oil is actually transported through the region? The answer is 21 million barrels of oil per day (mbd), which equates to approximately 21% of daily global consumption. For the geographically challenged (myself included) The Strait of Hormuz is a narrow maritime passageway that connects the Persian Gulf and the Gulf of Oman.

Source: U.S. Energy Information Administration

The Persian Gulf is the Middle Eastern counterpart to the Pacific Ocean’s “Ring of Fire.” For the Persian Gulf, the danger comes not from shifting tectonic plates but from the different religious factions who are vying for power in the region. Keep in mind that the Persian Gulf is bordered by Iran, Iraq, Kuwait, Saudi Arabia, Qatar, the United Arab Emirates (U.A.E.), and Oman – the bona fide who’s who of Middle East unrest that also produces about 1/3 of total global crude oil supply.

For these countries, there are few viable options to bypass the Strait of Hormuz and get their product to market. Saudi Arabia and the U.A.E. have pipelines (see chart above) capable of moving oil to locations outside of the Strait of Hormuz, but total capacity is only 6.8 mbd or less than 1/3 of the total oil produced in the region. Hence, the strait, which is only 35 nautical miles wide at its narrowest point, is critical to global oil supply.

The charts below show the volume of oil shipped through the Strait of Hormuz (left) and the destinations for that oil (right).

While the U.S. is becoming increasingly energy independent, Asian countries are reliant upon Middle Eastern countries for a large portion of their oil demand. Given the importance of the strait to global commerce and Iran’s ability to impact traffic within it, it’s understandable why Iran uses it as leverage in trying to negotiate an end to U.S. sanctions. While it’s infeasible for Iran to close the strait for an extended period, the potential for (or actual) Iranian provocations will keep oil markets on edge. In a worst-case scenario (which seems increasingly plausible with news that a planned U.S. military strike on Iran last week was aborted at the last minute), a war in the Persian Gulf would push oil prices significantly higher and threaten the already tepid pace of global growth. Optimistically, cooler heads will prevail.

How the Mind Works Against Successful Investing (Entry #2 in a series on Behavioral Finance)

We begin our study of how specifically the mind works against successful investing with an exploration into Emotional Biases. As a review, at a high level, we divide biases into two categories:

Emotional biases lead to errors when feelings influence reason.

Cognitive biases lead to faulty reasoning based on mental shortcuts.

We are starting with Emotional Biases because they are more challenging to correct. Emotional biases are subjective, whereas Cognitive biases are objective. In truth, nearly every bias we will discuss infects our reasoning at some level. However, in shining a light on these biases by explaining what they are and how to address them, we should be able to minimize their influence with a little work. So…. let’s get to work.

Loss Aversion

One of the most potent forces affecting decision-making in financial matters is Loss Aversion. The researchers (Daniel Kahneman and Amos Tversky) credited with identifying Loss Aversion described the bias in simple terms “losses loom larger than gains.” As it turns out, losses loom A LOT larger than gains as research studies have shown the pain of losing is psychologically about twice as powerful as the pleasure of gaining. The results of these studies show the disproportional relationship between losses and gains, as highlighted in the chart below. In this particular study of participants’ reactions to gains and losses, a $0.05 profit (horizontal axis) is valued (vertical axis) at slightly less than 20, whereas a -$0.05 loss has a negative value of 40.

Are you Loss Averse? Consider a situation in which you are presented with two options for investing $50,000. Which scenario do you prefer?

A) Be assured you will get back $51,000.

B) Have a 50%/50% chance of either getting back $70,000 or $35,000.

If you answered A, you are demonstrating a Loss Aversion bias. Answer B not only offers higher potential upside ($70,000) but is also a statistically better bet because when you multiply the probabilities by the outcomes, the result is $52,500.

What’s interesting about the Loss Aversion bias is that while “Loss” is in the name, the bias affects decisions about both winning and losing investments. Indeed, the influence that Loss Aversion has on winners vs. losers transforms risk-taking behavior.

The old Wall Street maxim “You never go broke taking a profit” is factually correct, but the strategy for successful investing is to minimize losing positions while maximizing gains on winning investments. No investor will get every investment right, so it’s essential to capture a significant portion of the potential profit from lucrative investments to offset losing positions and continue to grow your portfolio. However, investors often sell winners too early out of fear that gains will be lost. As such, winning investments often stimulate risk-averse “take the money and run” behavior.

In contrast, losing positions encourage risk-seeking behavior. Research shows that investors don’t like to realize losses by selling positions with a negative return. Said differently, investors often hold-on to losing investments in the hope the price will rise to at least break-even. “Hope is not a strategy” is good advice and holding onto a position experiencing losses, in the absence of compelling evidence for the price to recover, is irrational and risk-seeking. That is, the potential for the investment to decline further in price introduces additional risk to the portfolio.

In sum, hanging on to losing positions and selling profitable investments too early decimates portfolio returns in the long-run. However, we are not advocating for selling every investment that loses money in the short-term and retaining all winning investments, as that approach can work against long-term portfolio appreciation as well. Instead, we are advocating for a middle ground. On that investment-decision-making middle ground investors acknowledge the pull of their emotions, but then set them aside and focus on data to make evidence-based buy/sell decisions.